Addressing the Looming Financial Crisis in Japan

As
March 31 approaches, Japan faces critical decisions regarding the
future of its economy. This deadline, which marks the end of the
financial year, is crucial because Japanese banks must account for
their assets and performance, which may fail to meet investors'
expectations. The fear is that a loss of confidence in the banks
will cause widespread distress in the financial system, which would
also affect the United States.

Bad
news in the Japanese economy is not new. Japan has experienced
stagnant growth and four recessions since 1990. Real estate prices
have fallen to their 1982 value, and taxpayers have paid for
approximately $1 trillion in failed stimulus packages over the past
decade. What makes the current recession more ominous than the
previous three is that it marks the first time in modern Japanese
history that asset and labor values have fallen simultaneously.

While the Bush Administration cannot
spearhead the process to reverse this downturn, it can and should
clearly communicate U.S. priorities to the Japanese government and
people and provide unequivocal political support for efforts to
enact reforms. The United States should also consider assembling
key economic and financial advisers to assist the Japanese
leadership in implementing reforms; creating an inter-agency task
force in the Administration, overseen by the National Security
Council, to coordinate communication with Japan and underscore the
critical security aspect of restoring vitality and confidence in
the Japanese economy; and formulating a last-resort contingency
plan to insulate the U.S. economy from a possible crisis in the
Japanese financial system. The contingency plan should promote
strong economic growth and trade with the rest of East Asia. It
should also ensure that the U.S. banking system is not unduly
exposed to Japanese banks and alert U.S. businesses and investors
that they will not be bailed out in the event of a Japanese
financial crisis.

The
Japanese government has been in denial about its economic problems
for more than a decade. This denial has gradually escalated a
difficult financial problem into one of enormous proportions, with
potentially serious consequences for the global economy. The Bush
Administration obviously cannot solve Japan's economic malaise.
That task awaits action by the government of Japan under the
leadership of Prime Minister Junichiro Koizumi.

The Path from Economic Success to
Disaster

A
decade ago, many argued that Japan would overtake the United States
as the world's pre-eminent economic power.2 Some
even speculated that Japan, not the Soviet Union, was America's
most pressing security concern. For instance, prior to his tenure
as Secretary of the Treasury, Lawrence Summers stated that "an
Asian economic bloc with Japan at its apex...is clearly in the
making. This all raises the possibility that the majority of
American people who now feel that Japan is a greater threat to the
U.S. than the Soviet Union are right."3

These warnings seem misplaced today as
Japan struggles to escape from its decade of economic stagnation
and recession. Despite recent poor performance, however, there is
no denying Japan's remarkable success over the past 50 years. With
economic growth that outpaced the average of Western economies,
Japan became one of the world's wealthiest nations on a per-capita
basis. Growth in real gross domestic product (GDP) averaged 5.1
percent between 1960 and 1999, including a remarkable average of
more than 10 percent during the 1960s. And Japan's GDP per capita
increased fourfold from $5,343 in 1975 to $23,257 by 1998.4 This growth outpaced the OECD
average on a purchasing power parity basis between 1975 and 1999.5 (See Chart 1.)

Japan's development from a war-torn
economy to an economic superpower was based on its tradition of
strong ties between the government and the private sector, which
date back to the Meiji Restoration. This political and economic
reform movement was launched in 1873 by a group of samurai who
overthrew the ruling Tokugawa shogunate that had allowed Japan to
ossify under a century of stagnation. The reformers were successful
in invigorating Japan by entwining its traditional values of hard
work, enterprise, and social cohesion with Western entrepreneurial
institutions and practices. However, they also left a legacy of
government-led industrial policy and market intervention, such as
protectionism and managed trade.

While the Meiji Restoration set the stage
for the industrialization of modern Japan, the process was
completed in the post-World War II reconstruction period. The
American occupation of Japan from 1945 to 1952, much like Admiral
Perry's arrival in 1853, transformed Japan's society and economy.
American reconstruction efforts focused on establishing a
democratic government, decentralizing industry, devolving
government authority, and broadening access to education. Although
imposed by a foreign and victorious power, these changes
corresponded with principles of the Meiji Restoration and,
therefore, were more readily acceptable to the Japanese people than
they might otherwise have been.6

The
liberalized economy of post-war Japan, however, was not a free
market. Japan's government remained actively involved in its
economy, providing vigorous protections and concentrating on
manufactures for export.7 Foreign investment was closely
regulated and even discouraged unless Japanese partners retained
control. The government subsidized new industries and the
modernization of old ones; purchased patents and licensing
agreements for promising technologies; and supported students and
professionals studying abroad--all in an effort to encourage rapid
industrialization.

Government intervention in the economy
also included directing capital and resources into favored sectors,
subsidizing exports and restricting imports, and artificially
suppressing the value of the yen.8 Japan's
financial system and interest rates were rigidly regulated and
controlled by the government to support export-led economic
growth.9 Additionally, government
policies successfully encouraged high rates of household savings.
Private markets played only a minor role in guiding those savings
to the corporate sector.

Government activities were spearheaded
through bureaucracies such as the Ministry of International Trade
and Industry (MITI), the Federation of Economic Organizations
(Keidanren), the Industrial Structure Council, and the Economic
Planning Agency. These agencies maintained contacts with industry
and other government bureaucracies to coordinate efforts, including
working with the Development Bank to provide subsidized financing
for favored businesses or industrial sectors.10 Such a
coordinated strategy helped launch many Japanese industries as
world market leaders of exports in their sectors.11 However, many private-sector
industries, such as the auto, machine tool, and computer
industries, defied government efforts to limit competition, and to
the benefit of their businesses as well as the overall economy,
their competitive efforts earned them great success in
international markets.12

Weaknesses Camoflaged by Past Success

Following such a pattern of development,
Japan was widely trumpeted as the ideal model for economic success
in the 1970s and 1980s. Developed and developing countries alike,
including even the United States, were urged to follow Japan's
blend of industrial, trade, and financial policies of
government-guided protectionism combined with an emphasis on
capital markets, high personal savings, and an educated,
disciplined workforce.13

But
many of the policies credited for Japan's dramatic economic success
in the 1970s and 1980s are now at the heart of its current malaise.
The government's success in aiding certain industries, such as
steel and auto manufacturing, is overshadowed by its failure to
develop industrial dominance in other industries such as the
chemical, plastics, aerospace, aircraft, and software industries.14 This suggests that government
successes were achieved when policies simply boosted industries in
which Japan had an existing comparative advantage but that
government efforts to support industries that lacked comparative
advantage were insufficient to counter market forces.

Micromanaging Domestic Production

Today, the government's continued
intervention in support of declining industries only worsens
structural inefficiencies in the economy. For example, in the
construction, agriculture, or food industries, when domestic demand
declines, the government intervenes by coordinating plans to reduce
production rather than allowing market forces to prevail and force
consolidation or closure of the least competitive elements of the
industry.15 The lack of free-market
competition is a serious weakness highlighted by Japan's current
poor economic situation and is a major impediment to recovery.

Intervening in International
Competition

Another example of inefficient government
intervention is in the area of international trade. When a business
sector can no longer compete internationally, the Japanese
government increases barriers to foreign imports to reserve the
domestic market for these noncompetitive industries and subsidizes
foreign exports.16

While these practices are politically
attractive in the short term in that they keep domestic businesses
operating and unemployment low, they have significantly negative
long-term consequences for the economy. As capital is displaced
from healthy businesses to "zombie" corporations that would
otherwise expire in a free market, competitive players are
prevented from expanding their operations. This feature of the
Japanese economy, as Michael E. Porter observes in The Competitive
Advantage of Nations, creates a

study in contrasts. On one hand, [Japan]
contains some of the most competitive firms and industries in the
world.... On the other hand, however, there are large portions of
the Japanese economy that not only fail to measure up to the
standards of the best worldwide competitors but fall far behind
them.17

The
United States has also fallen victim to this practice, as
demonstrated by President George W. Bush's recent decision to
increase tariffs on steel products to protect domestic producers.
However, unlike Japan, the United States does not do this widely or
regularly. The sectors that were most sheltered by the Japanese
government in the past decades are now the least successful.
Regulation and control of the domestic health sector, for example,
has retarded innovation and lowered productivity.

The
inherent dichotomy of an economy that is characterized by a
vigorously competitive export orientation and a focus on increasing
innovation and productivity, as well as vastly inefficient
protectionist business relics sheltered from foreign and domestic
competition, prevents Japan from realizing an economic recovery.
While the burden of these contradictory impulses could be borne
during the years of economic expansion, it can no longer be
tolerated during a period of prolonged stagnation.

A Lost Decade

Japan must embark on a new economic path
and depart from its "lost decade." In 1986, Japan began to
experience rapid inflation in land prices and equity, and entered
into what is commonly referred to as a "bubble economy." The bubble
was created when the Bank of Japan pursued a policy of limiting the
appreciation of the yen and simultaneously increasing liquidity and
money supply. This excess liquidity was invested in assets,
artificially driving up asset values.

The
bubble burst when the Bank of Japan became concerned about the
rapid escalation in asset prices and doubled the discount rate
between May 1989 and August 1990, dramatically increasing interest
rates and chilling new borrowing. The resulting collapse in asset
prices led to Japan's most serious recession since World War II.18

This
recession was the precursor to more than 10 years of stagnation and
lackluster growth. (See Chart 2.) Japan has experienced a number of
periods of real GDP contraction since 1990, and growth during this
period averaged a dismal 0.37 percent. The recession of 1989-1990
hit the financial industry particularly hard by weakening balance
sheets, and companies that were heavily invested in real estate
took a strong hit.

Japan's response to the burst of the asset
bubble was guided, as usual, by the powerful bureaucracy and was
marked by denial, delay, and obfuscation. Asset prices fell below
the borrowed values. In the United States, this would lead banks to
call in loans or demand additional collateral.

In
Japan, however, because of political pressure and business
relationships, banks were reluctant to foreclose on bad loans that
would show a loss, choosing instead to maintain non-performing
loans on the books. Worse yet, many extended new loans to bankrupt
businesses. (See Chart 3.) As non-performing loans account for an
increasing portion of overall bank assets, there has been a decline
in new loans, since debt-ridden banks lack the resources to extend
new loans while they keep non-performing loans on the books.
Failure to resolve bad debt has weakened the overall health of the
financial system and stymied economic recovery.

The
jusen--hybrid subsidiaries comprised of banks and insurance and
securities firms--illustrate the problem facing the Japanese
economy. First established in the 1970s to provide consumer credit,
the jusen instead became heavily involved in the real estate bubble
in the late 1980s.

Despite clear evidence of widespread
insolvency throughout the jusen after the bubble burst, the
Ministry of Finance did not close down the subsidiaries; instead,
it allowed them to continue to operate based on the assumption that
real estate prices would rise--a speculation that proved
ill-founded. A 1995 Ministry of Finance audit of the jusen "found
that of the total ¥13 trillion [$97 billion] of jusen assets,
non-performing loans were estimated at ¥9.6 trillion [$72
billion], of which ¥6.4 trillion [$48 billion] was considered
unrecoverable and ¥1.2 trillion [$9 billion] was considered a
possible loss."19

The Current Malaise

Factors impeding the implementation of
policies to address Japan's economic problems include bureaucratic
intransigence, lack of political will, powerful interest groups
with much to lose under reform, and the relatively minor impact of
the crisis on the daily lives of the average Japanese citizen. This
last is particularly important because it explains the lack of
outrage among the Japanese people regarding the government's
failure to take effective action.

Essentially, the Japanese government's
strategy has been to borrow from international capital markets and
live off the capital built up during its industrial boom a decade
ago rather than undertaking painful but necessary reforms,
overhauling weak industries and forcing banks to revamp lending
practices. This has allowed Japan's citizens to maintain their
standard of living, concealing the true costs of the lost decade of
growth.

As a
result, despite the economy's decade-long faltering, only in recent
years has unemployment risen significantly and consumer spending
fallen. (See Chart 4.) This delayed effect was the result of a
government policy dedicated to propping up failing businesses to
avoid restructuring and layoffs, which for a time allowed workers
to continue their employment and consumption patterns.

The
fact that unemployment has dramatically increased and consumption
has decreased recently serves only to illustrate that government
intervention can delay but ultimately cannot nullify the impact of
poor economic performance. Instead of implementing the politically
tough reforms necessary to restructure the economy and bring about
a turnaround, the government has engaged in a series of ineffective
stimulus packages and bailouts that have done little but increase
the public debt, further exacerbating economic recovery. (See Table
1 and Chart 5.)

Government expenditure as a percentage of GDP has
risen by 20 percent since 1990 and government debt has nearly
doubled, due largely to the costs of large infrastructure projects
and bailouts provided for the banking industry. Not only has
government spending provided no discernible effect on economic
growth, but the immense burden of national debt has escalated to
levels that now raise serious doubt about Japan's ability to
service it.

This
deteriorating fiscal situation has been reflected in international
sovereign credit ratings for Japan, which have been increasingly
pessimistic. Since Japan was first graded in 1975, Standard &
Poor's sovereign credit rating service consistently rated Japanese
sovereign debt at the highest level. In the past year, however,
Standard & Poor's downgraded Japan twice from AAA to AA+ to
AA.20 Moody's Investors recently
announced that it may further downgrade Japan's sovereign credit
rating to that of the Bahamas and Botswana at A.21

While Japan's economic problems are not an
imminent threat to international markets, there is no doubt that
Japan's situation is worsening and that failure to reform will
ultimately lead to a crisis. The situation will reach a point of
crisis if Japan's sovereign debt rating falls below investment
grade (BBB to AAA according to Standard & Poor's or Baa to Aaa
according to Moody's). If Japan's sovereign debt should fall below
investment grade, international investors would be reluctant to
hold it and Japan would have to pay much higher interest rates to
borrow in international capital markets. This would effectively put
an end to Japan's budget policy of borrowing to finance domestic
spending.

With
the U.S. economy itself in a state of recovery, the Bush
Administration must continue to pressure Japan to be aggressive in
pursuing reform. After a decade of denying reality and refusing to
implement the reforms necessary to spur a true economic recovery,
the Japanese government must now undertake measures to salvage its
own economy and ensure the stability of the global economy.

What Must be Done to Set Japan on the Path
to Economic Viability

Prime Minister Junichiro Koizumi entered
office in April 2001 on a wave of popular support for his campaign
promises of much-needed reform. Nearly a year later, while
political and economic reforms remain at the top of his stated
agenda, little tangible progress has been made. Despite the efforts
of his government, Japan has slid into its fourth recession since
1990 and unemployment has now exceeded 5 percent. Deflation is a
reality, and non-performing private debt continues to hobble the
banking system. In addition, extensive Keynesian-style stimulus
initiatives through government-funded infrastructure projects have
caused public debt to balloon.

The
economic impact of a decade of lost growth is clearly illustrated
by the decline of Japan's leading businesses. In 1989, reports
Business Week, seven of the world's top 10 businesses according to
market capitalization (including the entire top five) were
Japanese. In 2001, not a single Japanese business was listed in the
top 10 of the survey's list, and only two were in the top 25.22

Japan's lackadaisical attitude toward
resolving these problems over the past decade can no longer be
ignored. The Bush Administration obviously cannot solve Japan's
economic malaise. That task awaits action by the government of
Japan, particularly the ruling Liberal Democratic Party and current
Prime Minister Koizumi.

What the Japanese Government Must
Do

The
Japanese government must end the dangerous spiral of deflation. The
latest GDP figures for the fourth quarter of 2001 reveal that there
was a 12 percent drop in private-sector investment. This in effect
nullifies a 1.9 percent increase in private consumption and a 2
percent rise in household consumption for the same quarter.23 To prevent a skeptical public
from becoming completely inured to the prevailing mood of political
paralysis, the leadership must act quickly to:

Terminate
ineffective Keynesian infrastructure projects. Japan has
spent nearly $1 trillion on 10 different stimulus packages in the
1990s with no lasting positive impact on economic growth.24 As a result of these
expenditures, public debt has ballooned to nearly 140 percent of
GDP--over $6 trillion, the highest level of any major developed
economy.25 In Keynesian theory, it is
assumed that stimulus packages will prime the pump for economic
recovery, but Japan's strategy has increased debt without
generating anticipated economic growth. This indicates that the
spending was poorly invested and, as a result, only further
undermined the country's financial health.

Resolve the
problem of non-performing debt. Non-performing loans have
accounted for an increasing portion of overall bank assets,
resulting in a lack of funds to finance new loans that impeded
recovery. Foreclosures are necessary to resolve these problems. The
Resolution Collection Corporation was established in 1998 for this
sole purpose. But the RCC has purchased and resold only $139
billion in non-performing loans.26 This
amount is minuscule compared with the private sector's $1.768
trillion estimate of non-performing loans. The RCC should be
encouraged to be more aggressive in disposing of bad debt.27

End government
subsidies and protection for private businesses. The
government should end its support of the private sector, such as
its implicit bailout of the debt-laden retailer Daiei. Instead, it
should initiate legislative changes to encourage corporate
restructuring and more flexible deployment of workers. In 1999, the
government injected banks with $56 billion of taxpayers' money to
prevent them from collapsing but did little to encourage distressed
corporate borrowers to downsize efficiently. That failure
contributed greatly to the impending crisis in the financial
sector.28

Embrace
free-market competition. Japan needs to increase domestic
competition by allowing large and inefficient businesses to fail
unless they are restructured into slimmer, potentially profitable
operations. This may entail painful mass layoffs, which
traditionally are anathema to the Japanese. Competition can be
further increased by deregulating and breaking up the old cartel
structure of the nation's banking system. The government already
has made efforts to further this goal with plans to end government
guarantees of bank assets, but this reform measure has been delayed
several times due to political pressures.29 Prime
Minister Koizumi must ensure that these plans are implemented
without delay, for they are key to reforming the failing the
banking system.

Reduce
taxes. Resuming economic growth requires increasing
private consumption. The most efficient way to accomplish this is
to increase the resources that are available for individuals to
spend by lowering the tax burden.

Recovering from the economic problem
acquired through 10 years of willful inaction is no simple task and
will be accomplished quickly. However, failure to undertake these
tough reforms will consign Japan's economy to a steeper decline
that will lead ultimately to an economic crisis that harms other
economies, particularly in East Asia, and further undercuts a shaky
global economy.

What the
U.S. Government Should Do

Reforming the Japanese economy is
obviously a domestic Japanese issue that must be initiated, led,
and managed by the Japanese leadership and people. Nevertheless,
the United States can and should play a key role in assisting Japan
in its turnaround by doing the following:

Provide
unequivocal political support to Japan. One of the most
important tasks, and perhaps the only one available to the United
States, is to provide vigorous support to the Japanese leadership.
The momentum behind Prime Minister Koizumi's reform efforts has
been waning in recent months, and the United States can do much to
lend both credibility and a sense of urgency to the difficult tasks
ahead. But the Bush Administration, instead of repeating the
mistakes of the previous Administration, should refrain from
badgering and bullying the Japanese on their lack of progress. In
the past, such tactics were not only fruitless, but damaged the
U.S.-Japan alliance. Rather, the United States should play a strong
and positive supporting role.

Assist the
Japanese leadership. The Bush Administration should
assemble a group of key economic and financial advisers to work
with their counterparts in Japan to assist in financial reform.
This group can provide key lessons learned from America's own
savings and loan crisis in the 1980s and assist in the technical
aspects of implementing new policies.

Communicate U.S.
priorities to Japan. The Bush Administration must make
clear to the Japanese leadership that Washington will not overlook
any lapses in financial, economic, and political reform in exchange
for Tokyo's support of the American war on terrorism. While
Japanese support in the war effort is vital, repairing the Japanese
economy must take priority; a stable and prosperous Japan is the
key to U.S. security interests in Asia.

Create an
inter-agency task force in the Administration. President
Bush should consider creating an inter-agency task force, comprised
of key officials from State, Treasury, Commerce, and the security
organizations and coordinated by the National Security Council.
Members of this task force could serve as a key advisory group for
their counterparts in Japan and establish clear and direct channels
of communication. More important, the task force would underscore
the critical security aspect of restoring vitality and confidence
in the Japanese economy.

Formulate a
contingency plan. Because the recovery of the Japanese
economy is ultimately a Japanese and not an American task, the Bush
Administration should, as a last resort, devise a contingency plan
to deal with a possible crisis in the Japanese financial system.
This plan must first work to ensure that the U.S. economy is not
unduly exposed to a systemic failure in Japan and insulate the
United States from the negative repercussions of a Japanese
financial crisis. This means the Federal Reserve and other banking
regulators should ensure that the U.S. banking system is not unduly
exposed to Japanese banks. Second, the President and Congress must
work to strengthen the American economy, as well as to increase
economic growth in the rest of East Asia and around the world, by
adopting sound economic policies and promoting free trade. Finally,
in the event of more serious Japanese downturn, the Bush
Admin-istration should state unequivocally that U.S. businesses and
investors will not be bailed out. The East Asian financial crisis
and the past decade of poor economic growth in Japan provide ample
evidence of the risky nature of foreign investments, and U.S.
businesses should take account of this evidence in their risk
assessments.

Conclusion

Japan's economic performance in the past
decade has clearly refuted the arguments of those who hailed
Japan's economic system as superior to American-style capitalism.
Japan's impending financial crisis belies such declarations as
James Fallows' statement in 1989 that "Japan and its
acolytes...have demonstrated that in head-on industrial competition
between free-trading societies and `capitalist development states,'
the free-traders will eventually lose."30

Rather than dominating the global economy,
Japan is experiencing its fourth recession in a decade. Real estate
prices have fallen to their 1982 value, leaving many people and
businesses with mortgages greater than the value of their property.
There have been four major bank bailouts since 1998. Whether
Japanese industrial policy, protectionism, and autonomous
bureaucracy contributed to Japan's rise or simply coincided with
it, there is no doubt that these factors eventually destroyed
Japan's economic vibrancy and are now hindering the country's
recovery.

Japan's resistance to free-market
capitalism is the source of its current malaise, and a failure to
address this issue will make a future crisis in Japan inevitable.
For the good of Japan and the global economy, the Bush
Administration should work closely with the Japanese government and
convince leaders of that nation to undertake long-delayed reform.
If Japan is unable to forge a new path for recovery, its influence
will continue to erode, and the centrality of the U.S-Japan
relationship in Pacific affairs will correspondingly diminish.

Balbina Y.
Hwang is Policy Analyst for Northeast Asia in the Asian
Studies Center, and Brett D. Schaefer is
Jay Kingham Fellow in International Regulatory Affairs in the
Center for International Trade and Economics, at The Heritage
Foundation.

1.The authors would like
to thank Research Assistants Anthony Kim and Kimberly Thompson for
their help in preparing this paper.

3.Richard Katz, The
System that Soured: The Rise and Fall of the Japanese Economic
Miracle (Armonk, N.Y.: M. E. Sharpe, 1998), p. 9.

4.World Bank World
Development Indicators 2001.

5.Ibid.

6.See George C. Lodge and
Ezra F. Vogel, Ideology and National Competitiveness: An Analysis
of Nine Countries (Boston: Harvard Business School Press, 1987),
pp. 144-155, and Competing Economies: America, Europe, and the
Pacific Rim, Office of Technology Assessment, Congress of the
United States, OTA-ITE-498 (Washington: U.S. Government Printing
Office, 1991), p. 239.

7.Initially, these
exports were textiles and low-grade electronics; but as wages
increased, lowering the competitiveness of these products, the
government subsidized investments in heavy industries like steel,
machinery, ship building, and automobiles. See Lodge and Vogel,
Ideology and National Competitiveness, p. 164.

24.Chikahisa Sumi,
Counselor for the Ministry of Finance, Embassy of Japan,
Washington, D.C., "Japan's Economic Woes and Its Impact on the
Region," presentation at the Heritage Foundation, February 26,
2002.

25.James Brooke, "Some
Japanese Are Hoarding Gold," The New York Times, March 14,
2002.

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Japan's resistance to free-market capitalism is the source of itscurrent malaise, and a failure to address this issue will make afuture crisis in Japan inevitable. For the good of Japan and theglobal economy, the Bush Administration should work closely withthe Japanese government and convince leaders of that nation toundertake long-delayed reform.

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